What is a liquidity pool in crypto trading?

What is a liquidity pool in crypto trading?



Liquidity pools are virtual smart contracts that contain two cryptocurrencies. Supplied by liquidity providers, these pools facilitate buying and selling different cryptos in different pools.

Having these pools, crypto exchanges and brokers can provide a smooth crypto trading experience for traders. It is much easier to buy and sell tokens that are available in the pools, as they are liquidated much faster and you don’t need to have an actual buyer.

A liquidity pool is an alternative to the classic book that records stock exchange market transactions, it is virtually stored and locked. These pools are the foundation of the decentralized financial system, where several decentralized exchanges operate and administer the crypto trading process.

There are different protocols that administer different pools, and each of them provides different services and fees for the users. In this guide, we will discuss the role of liquidity pools in crypto trading and everything else you might need to know.

How Liquidity Pools Are Created

Classically in any financial market, other than the cryptocurrency market, the buyer and the seller meet in the marketplace to conduct a transaction. 

This transaction relies heavily on market makers, who buy and sell from traders in different markets. However, replicating this in a decentralized financial market like the cryptocurrency market is not very efficient because it is slow and expensive.

Therefore, liquidity pools were created to always provide liquidity for the huge amount of transactions done in the cryptocurrency market. Liquidity providers contribute to this pool by adding an equal ratio of crypto coins.

But how are these liquidity pools created? Liquidity pools are created using smart contracts where anyone can provide liquidity for different rewards. These pools are usually a combination of two different cryptocurrencies and traders can exchange one for another in a fast and smooth way. 

These liquidity pools are not limited to only two tokes, and some liquidity pools can contain up to 8 cryptocurrencies.

How Liquidity Pools Work

Liquidity pools are comprised of liquidity providers who create these pools and set the price. There are protocols that secure these pools in virtually locked contracts. Also, there are exchanges and OTC brokers who use them to facilitate trading.

Automatic Market Making is the mechanism that admins the transaction process of the liquidity pools. Using the AMM, all three participants of the liquidity pool interact with each other.

Liquidity providers

The liquidity providers are investors, banks, or financial institutions that add equal pairs of tokens in one pool. One or more liquidity providers can contribute to one liquidity pool, and they set the price according to the market price.

If the price of the tokens in one pool diverges from the crypto market, it will make these pools not useful and is more likely to create liquidity issues.

In return, liquidity providers receive a special token or interest rate, to compensate them for adding to the pool. The liquidity provider or LP token that they receive entitles them to a share of the revenue generated by the pool according to their contribution.


Crypto exchanges are marketplaces where cryptocurrencies are traded. They are platforms that offer several coins, and where a huge number of buyers and sellers come to trade them.

But most of these exchanges use traditional order books in order to create liquidity. For highly traded assets, this might do the job, but for assets that are not traded as much, this order book becomes a problem.

Because of this, exchanges started to utilize these liquidity pools in order to make the trading experience on their platform smooth and fast. It does not matter if these are centralized or decentralized exchanges, both of them are benefiting from these pools. 

But what benefit do traders get from providing liquidity? Well, the answer to this question is crypto. Whenever we provide liquidity for an exchange, in return we will get a native token of that exchange as a reward. For example, when we provide liquidity for Binance, we receive BNB, their native token, as a reward. Some liquidity pools even reward traders with the same token they provided liquidity for.

The Role of Liquidity Pools in Crypto Trading

Well, we know that the role of liquidity pools is to create liquidity. But why are we so desperate for liquidity? 

Cryptocurrencies are a relatively new concept of financial trading/investment, but they still managed to gather global attention and now stand beside other financial assets such as stocks, FX, and more.

Because of this popularity, a huge number of traders are joining the market each day to try their luck in this volatile market, and this is where the problem lies. Cryptocurrencies tend to be highly volatile which means that their price changes consistently. So if we were to send a buy order of a set amount of tokens, the price that the exchange gave us at the start might not be the final price because of slippage. If the market could not fulfill our order in time and the price changes, we will be paying a different price than when we sent the order.

Liquidity pools help us to execute these orders in seconds and avoid any slippages.

How do these pools affect the price of crypto tokens

The liquidity pools aim to have the tokens always available using automatic market-making, which makes the transactions faster. For example, if a pool contains an equal amount of BNB/ETH, it will be faster for a trader to buy ERC-20 (the ETH token) because it is always available.

The protocols that govern the liquidity pools motivate the liquidity providers by offering them a special token, or in most cases a fixed interest rate for every transaction that takes place in the liquidity pool.

Liquidity providers need to maintain an equal balance between the tokens in the pool. Otherwise, if there is an unequal amount of tokens, it will cause an imbalance in the demand and supply law, and eventually will lead to price changes.

However, ensuring a balance is necessary in order to have a token price that copes with the market price, and any parity from the market price will cause the pool to be not practical, expensive, and unprofitable for the liquidity providers.

What Did We Learn From the Liquidity Pool in Crypto Trading?

  • Liquidity pools contain cryptocurrency tokens and use automatic market-making to always ensure the liquidity of these tokens
  • Transactions conducted in the liquidity pools are faster and smoother because there is higher liquidity, and traders do not need to wait for a seller in the market
  • Liquidity providers supply these pools with an equal ratio of token pairs, in exchange they receive a royalty token or an interest rate from any transaction
  • Liquidity pools use different protocols to be registered on a blockchain like the Ethereum blockchain, these protocols take care of the token’s security and maintenance

FAQs on Liquidity Pools in Crypto Trading

Can you lose money in liquidity pools?

The impairment loss is one of the risks associated with the liquidity pools. The liquidity providers need to invest to keep the pool running, and if their expenditures are higher than gains, it will cause them to lose money, and might eventually pull out to avoid excessive losses.

How do you profit from liquidity pools?

Liquidity providers invest their capital in these pools to add more tokens and maintain the liquidity of the pool. In exchange, these investors receive interest from every transaction that happens on the pool, as well as a special token called the provider’s token.

How do crypto liquidity pools work?

Liquidity pools contain a huge number of tokens, making it smooth and fast to buy and sell tokens using these pools. The tokens can be purchased using cryptocurrencies, where traders pay in cryptos to buy a token in a much faster process.

Is it good to invest in a liquidity pool?

There are several benefits you can receive from investing in liquidity pools. These benefits include receiving unique tokens which are physical assets that you may sell for a profit. Other benefits include a high rate of returns, if the pool performs very well, and many transactions take place, you are more likely to witness an increased income from this investment. Note that you don’t need to take care of the pools, they are maintained by the developers of the blockchain they are registered at.